This Week's Q & A

Q: When someone dies and leaves a residence to an heir, what happens to the outstanding mortgage on the property?

A: Most mortgages contain a “due-on-sale” clause, giving the lender the right to demand payment-in-full of the outstanding loan if the property is sold or ownership is transferred. In the situation you describe, where the owner has died, the attorneys I consulted explained, lenders typically allow up to one year for the estate to be probated. During that period, the estate steps into the owner’s shoes and takes over the mortgage payments. When all the details have been finalized, the estate transfers ownership to the indicated heir (or heirs), and at that point, the due-on-sale clause kicks in – at least, in theory.

As a practical matter, banks acknowledge privately (although none will say this publicly), that as long as the mortgage payments are being made, they’re not likely to know, or particularly care, that the property is in the hands of a new owner.

The problem comes, of course, if they do find out. That would happen if you seek to refinance the loan (not a wise move if you don’t want the bank to know what’s happened) or if, for some reason, you are no longer able to make the payments. Let’s say you do encounter financial difficulties and miss a payment or two. The bank would investigate, discover that you are now the owner of record, and exercise its right to call the loan. Since you are already having financial problems, the timing would be inconvenient, to say the least. And if the real estate market also is weak, you may not be able to sell the house, or sell it for enough to pay off the mortgage. You see the risks. Add to the financial pressures the possibility that the bank could sue you for fraud, and hit you for the attorneys’ fees and other costs related to that action. Again, this isn’t likely, but it is a possibility you should consider.

One point worth noting here: There is a reason for the due-on-sale clause and it’s not simply to make life difficult for heirs. Before approving a mortgage, lenders carefully consider the credit history and financial strength of a prospective borrower. If you step secretly into that borrower’s shoes, the lender has no way of judging your capacity or your willingness to repay the loan – until you stop making the payments. Lenders have an obvious interest in ensuring that the people responsible for making the mortgage payments will actually do so.

Instead of taking over the mortgage and hoping no one notices, you could approach the bank after inheriting the property and ask to be allowed to assume the loan. Many portfolio lenders would be willing at least to consider the proposal, and even secondary market lenders, although constrained by investor restrictions on assumptions, often have more flexibility than borrowers assume. If you can qualify for the loan, many lenders would be willing either to approve the assumption, refinance the existing mortgage, or offer you a new loan. Expect lenders to be more enthusiastic about the assumption option if the rate on the existing loan is above prevailing market rates; if current rates are higher, don’t count on keeping the favorable rate under any arrangement lenders are willing to offer you.